High-Quality RenRe Not A Striking Bargain

Investors are fairly spoiled for choice when it comes to the insurance sector, so not only can they afford to be picky, but they pretty much have to be. With the sector having been relatively strong of late, despite weak investment returns, a lot of the great bargains in the space have disappeared. RenaissanceRe (NYSE:RNR) is a difficult case in point; while this company remains a top-flight reinsurance company and is not exactly overpriced, it's not that much of a bargain either.

Conditions Improving, but...On first blush, last year was about as bad as it gets for insurance underwriters. There were multiple serious earthquakes, severe storms like tornadoes and hurricanes, and major flooding in Australia and Thailand. Not surprisingly, reinsurance companies like RenRe and PartnerRe (NYSE:PRE) reported losses for the year, while Arch Capital (Nasdaq:ACGL) reported a significant drop in profits.

As it turns out, though, 2011 wasn't as much of a disaster as you might imagine. Most of the major insurance companies were in good shape with respect to their reserves, and investors have since looked back on the disasters as a potential catalyst for a harder market (that is, higher premiums). And they have been right - prices have increased in markets like Japan and Australia, as well as Florida.

Competition Is Whittling Down the PricesUnfortunately, while rates have improved, they haven't been improving as much as Wall Street's sell-side community had been hoping. Based on the reports coming from companies like Arch Capital, PartnerRe, Everest Re (NYSE:RE), XL Group (NYSE:XL) and RenRe, pricing in Florida has been increasing more on the order of mid-single-digits instead of the high-single-digits that analysts had projected. Likewise, while the pricing jumps in Japan look gaudy, they have been easing off.

Why is pricing coming in weaker than expected? The disasters and catastrophes in 2011 didn't destroy capital or investor interest in the sector like 9/11 or Hurricane Katrina did. Consequently, there has been pretty active issuance of cat bonds and formation of side-cars and hedge fund-sponsored start-ups. All that means is that there's a lot of capital looking for underwriting business.

Now, RenRe has been pretty aggressive in expanding its side-car business, as well as putting excess capital to work in writing reinsurance business. Nevertheless, lower-than-expected pricing may start to lead analysts to rein in earnings and book value growth assumptions.

Can RenRe Maintain Its Advantage and Double-Digit ROEs?RenRe has long been a leader in property reinsurance, using sophisticated risk analytics and modeling to generate superior returns. It's worth asking if those superior returns are sustainable. Post-9/11 and Katrina, most of the surviving or newly-created insurance companies have intensified their risk-modeling efforts and the industry may have closed some of the gap with RenRe. Likewise, as RenRe grows larger, it's going to be harder and harder to maintain those returns (absent large returns of capital to shareholders).

It's also worth noting that RenRe is highly dependent on brokers. Nearly 90% of the company's business goes through Aon (NYSE:AON), Willis (NYSE:WSH), or Marsh & McLennan (NYSE:MMC). It's hard to get worked up about this as a risk factor, as it has been the case for so many years now, but it's worth noting all the same.

The Bottom LineBerkshire Hathaway is a very good example of the sort of capital and returns that a well-run reinsurance business can produce. RenRe isn't "another/the next Berkshire," but it is a very well-run property reinsurance company. I do believe investors can depend upon this company to produce returns on equity and book value growth that put it in the top tier of reinsurance companies over the long run.

That said, today's price is not immensely compelling. Assuming that RenRe can maintain low teen ROEs for the long term, the stock is about 10-15% underpriced today. That's not a bad "hold" and may even be enough for long-term investors, but it doesn't make for the greatest buy on the market.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.